Corporate Governance & Responsibility

The Issue of
Corporate Governance

Recent headlines have brought the issue of
corporate governance to everyone's attention. We have all seen the many stories
about Enron, WorldCom, Adelphia, and other companies that were once mainstays
of our economy and our business community. Television has brought us images of
corporate executives, not being recognized for their civic contributions but
being led away in handcuffs on allegations of malfeasance.

A common refrain in all
these stories is that company executives were not acting in the best interest
of their organizations, their shareholders, and their employees. A combination
of inadequate monitoring, a breakdown in internal controls, and the systematic
failure of both outside directors and outside auditors appear to have led to a
less than desirable outcome.

Why Has This
Happened?

Several reasons have been offered to explain why these
corporate governance problems have recently gained the spotlight. Some have
argued the origin of these problems was the mega-merger and takeover wave of
the 1980s, when innovative compensation programs for top executives were
established - including a significant increase in the use of stock options.
While these programs were supposed to improve management's incentives to
increase shareholder value, some see them as the seeds of our current
problems.

These compensation
programs expanded and covered more companies during the 1990s. For example, in
1990, equity-based compensation for CEOs was 5 percent of total compensation.
By 1999, it was 60 percent. Stock options rose from 5 percent of outstanding
shares in U.S. companies in 1991 to 15 percent a decade later. Meanwhile, the
value of stock options in the largest 2000 companies in the U.S. more than
tripled between 1997 and 2000.

Detractors argue that
these changes in executive compensation tended to place more emphasis on short-term gains in a company's stock price, rather than on long-term performance. Then, the 1990s brought about rapid changes in
technology, greater deregulation, and increased globalization of markets. This
placed more pressures on companies' cash flows and made it more difficult to
raise share valuations. The innovative compensation programs encouraged
executives to take greater risk or to engage in more creative accounting to
improve reported earnings. In effect, corporations shifted their business
standards and were not held in check by either their corporate directors or
others charged with guarding shareholder interests.

Another explanation of
recent events focuses on the fact that long-term earnings forecasts for many
companies were overly optimistic during the decade of the 1990s and generated
unrealistic expectations. Proponents of this view point out that three- to
five-year earnings forecasts for S&P 500 companies averaged almost 12
percent per year between 1985 and 2001. However, actual earnings growth over
that period was 7 percent.

Some blame analysts and
Wall Street for these overestimates of earnings. They argue financial firms
promoted and retained those analysts with the most optimistic forecasts of
companies' earnings. Interestingly, the bias to do so was especially pronounced
among analysts employed by the underwriting firm.

Still another
explanation of these scandals lays blame at the foot of the innovations in the
field of finance. By this view, these innovations outpaced the ability of
traditional accounting and auditing standards to monitor many corporations'
activities. They allowed some executives to engineer creative accounting
techniques to obfuscate earnings and conceal negative results. Consequently,
investors and outside parties had more and more difficulty understanding the
financial statements and the risk positions of these large, complex
organizations.

Of course, all these
suggested explanations received little attention when stock prices were rising
rapidly during the bull market. The sharp declines in stock prices have led to
greater awareness and concern.

In essence, the
foundation of trust was breached between corporations and shareholders with
regard to the meaningful disclosure of corporations' financial information. The
outcome was a break between executives' pay and the corporations' performance.
The whole process of reporting earnings and financial statements became
tainted.

An Old Problem with
Deep Roots

Although the problems outlined in these explanations
certainly played some role in recent events - or even a major role - focusing
on them gives the impression that corporate governance problems are a
relatively new issue. I disagree. Rather than a recent development, such issues
have deep roots. They are inherent in what economists call 'the principal-agent
relationship' in organizations.

The central dilemma
here is one of conflicting interests. Much research has been devoted to how to
provide incentives to the agent - or executive management of a firm, for the
purposes of our discussion - to act in the best interests of the principals -
the owners of the firm. In essence, the challenge of our form of capitalism is,
and has always been, to construct a system of corporate governance so that
company management acts in the best interests of shareholders.

This is what we have
attempted to do in our structure of corporate governance. The oversight of the
firm falls directly on the company's board of directors. In the end, the board
bears ultimate responsibility for the company's performance. The board is
supposed to implement methods to monitor and control management so that abuses
are prevented or at least minimized. To do this, some members of the board of
directors are outsiders - people who are not part of the management team of the
company. These directors are supposed to act as an independent check on
corporate management to ensure they act in the shareholders' best interest.
American capitalism relies on the fiduciary concept to protect those who
entrust their money to large - and often distant - corporations.

The Importance of
Corporate Governance

Yet today, there is a sense that the model just
described is not working well enough. A crisis of confidence in corporate
America has resulted. Recent scandals have generated a lingering sense of
uncertainty and vulnerability among investors. This has put pressure on
companies' management, corporate directors, and regulators to address problems
of accountability and control.

To restore public
confidence in the integrity of corporate America, companies must demonstrate a
strong commitment to the development and enforcement of rigorous standards of
corporate governance. These standards must encompass the relationship between a
company's board of directors, its management, and its shareholders. They must
require corporate leaders to be faithful to shareholder interests and act with
both competence and integrity.

At a very basic level,
trust is at the heart of the free enterprise system. But the current state of
public trust in American corporations is not good. According to a recent poll,
77 percent of the public believe CEO greed and corruption caused the recent
declines in the stock market. In addition, polls suggest much of the public
rejects the view that the scandals were isolated incidents within a system in
which most corporate leaders are good and honest people.

Yet, the continued
success of our economic system requires the confidence and trust of investors,
employees, consumers, and the public at large. In short, there is much work to
be done.

What Is Being
Done?

We know that as corporations grow larger and more complex, it
becomes more difficult for boards of directors to monitor activities across the
company. Directors cannot be expected to understand every nuance of or oversee
every transaction. They should look to management for that.

Nonetheless, the role
of a corporate board of directors is quite substantial, and directors are
required to be highly knowledgeable. They must know - understand - the nature
of the firm's business, its financial performance, and the nature of the risks
facing the firm's strategic plan. Collectively the board should have knowledge
and expertise in areas such as business, finance, accounting, marketing, public
policy, manufacturing and operations, government, technology, and other areas
necessary to help the board fulfill its role. They must set the tone for
risk-taking in the institution and establish sufficient controls so its
directives are followed. They also have the responsibility to hire competent
individuals who possess integrity and the ability to exercise good judgment.
Members of the audit committee, in particular, must be independent and have
knowledge and experience in auditing financial matters. This is no small task.

Recent events have been
a loud wake-up call, focusing attention on the need to heighten our commitment
to proper corporate governance and improve both accountability and control. In
response, a number of measures have been taken or proposed by various groups to
bolster confidence in our corporate system.

Recognizing that boards
have come under increased scrutiny, the New York Stock Exchange recently
appointed a Corporate Accountability and Listing Standards Committee. The
committee has come up with a number of recommendations to improve corporate
governance. One proposal is to increase the role and authority of independent
directors by having them make up a majority of a company's board. The committee
also recommends that companies adopt corporate governance guidelines and a code
of business ethics and conduct. In addition, the committee has suggested
shareholders be given more opportunity to monitor the governance of their
companies. They must vote on all equity-based compensation plans and have
access to the company's corporate governance guidelines.

The Conference Board
Commission on Public Trust and Private Enterprise has also made
recommendations on best practices. It recommended that executive compensation
be performance-tied and zero-based and stressed the importance of independent
directors being able to retain outside consultants. The commission also
suggests that the Federal Accounting Board (FAB) and the International
Accounting Standards Board (IASB) come up with standardized definitions of
revenues in order to achieve true parity in determining executive compensation
based on company performance. Finally, it recommended that America's senior
executives should be subject to much longer-term holding periods for company
stock and higher ownership requirements.

A consensus is now also
growing concerning some needed changes to certain underlying accounting
standards and their application. The U.S. Financial Accounting Standards
Board (FASB) is considering how to improve accounting standards for
special-purpose entities. This is in response to the growth of securitization
and the added complexity securitization has introduced into financial
reporting.

A pilot program is
under way to standardize financial reporting data and make them available to
investors via a web site hosted by Nasdaq. Going forward, technology
will be instrumental in improving transparency in financial reporting by making
corporate financial information easily available.

Congress has also
responded. The newest legislation about corporate governance, the Sarbanes-Oxley Act, addresses the wave of recent events that shook
public confidence. The act seeks to protect investors by improving the accuracy
and reliability of corporate disclosures. Among its major provisions is the
establishment of a new private-sector regulatory regime in which the SEC
handpicks an oversight board to monitor standards and conduct in the accounting
industry. Sarbanes-Oxley also emphasizes the need for a wall of independence
between auditors and firms. In addition, and perhaps most controversially, the
act seeks to strengthen corporate responsibility by creating a structure for
holding individuals and companies criminally and/or civilly accountable for
their actions. CEOs and CFOs are now required to certify quarterly and annual
reports to ensure proper disclosures.

While some may disagree
with any of these proposals, it is important to realize that those involved and
responsible have begun to take action to address the perceived problems of
corporate governance. I expect our panel will speak to these issues and of the
burdens these proposals place on affected organizations.

Corporate Governance
in Bank Regulation

It should be pointed out that the non-financial
sector is not alone in its search for better corporate governance. The
requirement of trust and confidence in corporate America is analogous to the
trust and confidence issues that the Federal Reserve faces in its role as the
regulator of the U.S. banking system. Let me touch on some of the parallels and
briefly describe how we have addressed them.

Of course, banks have
shareholders, too. Their business involves making loans to customers who are
expected to repay. Bank management has a good deal of information about the
quality of the loan portfolio. The question facing bank managers and their
directors is how much information to provide to shareholders. As stewards of
the public trust, bank regulators and supervisors ask the same
questions.

But beyond this, a
bank's relationship with its depositors is another example of the
principal-agent problem. Depositors depend upon bank regulators and
supervisors, as well as deposit insurance, to keep their money safe in spite of
the opaque nature of bank assets. As a result, we have substantial interest in
the ways in which corporate governance is performed in the regulated banking
sector, and we have incorporated these concerns into our regulatory and
supervisory model.

The primary focus of
the Federal Reserve's approach to supervision and regulation is ensuring an
institution's safety and soundness. The Federal Reserve's examiners also ensure
compliance with banking laws and regulations, including consumer-protection
laws and regulations.

Historically, a major
focus of banks and their regulators has been on whether they accurately report
their financial condition and appropriately assess the quality of their assets.
Beyond this, supervisors have long been concerned about the quality of internal
controls. During the past 15 years, the Fed's supervisory program has been
broadened to focus on banks' overall risk-management systems, comparing them
against both regulatory standards and industry best practices.

The Fed's
risk-assessment process analyzes the nature and extent of risk to which a
financial institution is exposed and assesses how well the institution is
identifying, controlling, and managing risks. It requires integrated,
enterprise-wide risk management that considers all areas of risk, including
credit risk, market risk, liquidity risk, operational risk, legal risk, and
reputational risk. The idea is to identify not only the type of risk and its
level but also its direction and whether the bank has means to effectively
control each risk.

The Fed also wants to
ensure that the bank has a strong internal audit function and that it also
receives a thorough, complete, and independent external audit. To accomplish
all this, Fed examiners conduct on-site examinations and provide institutions
with continual off-site monitoring and analysis as economic conditions and the
bank's financial condition change.

In 1991, Congress
broadened the scope of banks' assessments of risks and controls. Since then,
bank managers are required, at least annually, to step back from other duties
and evaluate risks and internal controls. In addition, external auditors must
attest to management's results of this self-assessment of risks and internal
controls. The results are reported to the audit committee of the bank's Board
of Directors. Incidentally, the audit committees of banks' boards have been
required to be independent of management for a long time - something that is
now being stressed for all corporations. In fact, this approach to
risk-assessment and internal controls is also the one followed by all of the
Federal Reserve Banks for several years.

Ensuring a broad-based
assessment of risks and internal controls has served the banking industry well
in recent years. For instance, despite the economic downturn in 2001, most
banks continue to be in good health.

But There Are
Limits

The Fed's experience, therefore, suggests some success with the
evolving model of better corporate governance. Nonetheless, it is important to
remember that the process is still evolving. Much work remains to be done. It
is important to remember that proposals to improve corporate governance must
take into account not only the expected benefits of new standards and
regulations but also their expected costs to both the corporations and the
economy as a whole.

Good intentions do not
always prevent unintended consequences - which is why a forum such as this one
can be very helpful in illuminating the potential pitfalls of well-intended
proposals. Some unintended side effects might include high compliance costs,
ambiguous liabilities, or reduced innovation. This is particularly true when
various proposals about corporate governance have been arising at both the
state and federal levels.

Disclosure should never
be so onerous as to make the cost of compliance prohibitive or impractical.
Regulations and standards of any sort - whether by regulators, government,
trade groups, or the companies themselves - should not excessively impede the
ongoing process of innovation. Rather, we must ensure an environment conducive
to markets that are effective and efficient, safe and sound.

I expect we will also
hear more on this from our panel members, both from an accounting
professional's perspective and from a CEO's perspective.

Is There a Better
Way?

But before we turn the program over to our panelists, let me
comment on the ongoing debate over the use of principles versus rules in the
effort to improve corporate governance. One criticism of the past approach to
corporate governance is it tended to focus on the development of fairly
specific rules of behavior rather than insisting on adherence to certain principles of behavior. Most of the proposals we now debate to improve
corporate governance are new rules.

However, the problem
with rules, particularly accounting-based rules, is that innovations in the
financial system can open loopholes in rules. When loopholes open,
inappropriate or unethical actions that are not specifically prohibited by the
rules can take place. Basically, this is what happened in many of the
corporations that made news headlines in the past year or two.

A credible case can be
made that we should focus on principles instead of rules. That is, we should
establish key principles against which corporate decisions should be held
accountable, regardless of whether a certain type of behavior is prohibited.
This way, when innovations make old rules obsolete, corporate leaders and their
financial executives would have to consider not only whether some action would
violate a rule but whether it would violate a principle.

There are strong
arguments for developing principles-based standards - in addition to our
reliance on traditional rules-based standards. However, the challenge is to
establish a set of principles that are sufficiently clear and concise. This may
not be an easy task, and the result may be substantial litigation, rather than
simplification and clarity. As was said earlier, it is important to consider
both the costs and benefits of new standards, as well as the unintended
consequences that may result. In the end, rules can not replace ethics and an
exemplary 'tone at the top.'

Nonetheless, whichever
way regulation evolves, disclosure and transparency are imperative to adequate
corporate governance. Such disclosure need not be identical across all
industries and companies. The information available to the public should be
what is necessary for them to evaluate a particular firm's risk profile. That
is why principles-based accounting has some appeal. Companies should take
action to ensure their financial statements divulge what is truly essential for
investors to understand the business and make informed decisions.

Conclusion

Let me conclude with this. Good corporate governance is critical to the
health of the corporate system, our financial system, and our economy. Our
economy will be stronger if corporate decisions are made with competence and
integrity, and if shareholders and the public can appropriately assess the
profitability and riskiness of corporations' business activities.

The crisis of
confidence in corporate America has been created by recent scandals that have
generated a sense of uncertainty and vulnerability among investors. These
events have put pressure on regulators, corporate directors, and management to
address problems of corporate accountability and control. Changes are in the
works and appear to be in the right direction. To a large extent, this
direction is where banks and bank regulators have gone before.

Many ideas to improve
corporate governance are being offered by a variety of parties. Adopting a
system of principles-based accounting standards, rather than primarily amending
the current rules-based standards, may be useful in ensuring that our
accounting rules do not become quickly out of date in the face of rapid
financial innovation. But given the wide range of ideas being offered, the
challenge will be to move forward and implement those proposals most likely to
be effective in yielding benefits at a reasonable cost of compliance and to do
so without generating unintended consequences. The challenge is in the
implementation, but the challenge is a noble one. We must proceed.

In the end, however, we
must bear in mind that the core principles of ethical behavior and sound
business practices are the keys to any real success in this arena. This tone is
set at the top. Without these values we will never really succeed in conquering
the problems and conflicts that arise in corporate governance.